How Do You Like Your Landing? Hard or Soft? Part 1

We frame changes in PCE and the GDP investment lines across the trailing 8 quarters as handicapping picks up.

In this two-part commentary, we frame some of our ideas around the hard vs. soft landing recession debate. There is of course always the chance of no recession at all, but the worry about the downside is the main event in the markets.  The descriptive categories such as “hard landing” offer a convenient way to generalize, but such terminology does not always capture the diverse nature of past recessions. We dig into the subject and produce some charts to help focus attention on the most important line items. 

In Part 1, we make some general points about which GDP metrics to really zero in on. We use the recently revised 3Q22 GDP growth number as a starting point. 3Q22 came in at a 3% handle (3.2% on the third estimate), which got the equity markets nervous again on what it means at the Fed. In Part 2, we will produce comparable key line items for time periods that bracketed the recessions of 1973-1975 after the oil embargo, the 1980-1982 double dip, 1990-1991 downturn that saw years of regional stress and financial system strife, 2000-2001 recession after the TMT bubble, and the crisis years of 2008-2009. COVID was an outlier with a 2-month recession in 2020 that saw record contraction and record rise for quarterly GDP growth.

The 3Q22 final GDP print is a springboard for a look back…

This week we saw the final 3Q22 GDP report and it cracked into the 3% handle range. So far, Biden has seen four quarters with 3% handles or higher GDP growth rates along with two negative quarters. Trump saw five quarters over 3% GDP growth rates in his one term and one massively negative quarter in 2Q20 to go with the even higher positive rebound in 3Q20. Obama saw 10 quarters over 3% in his two terms or right in line with Trump’s rate. Biden got a head start with the post-COVID rebound year off a brutal pandemic year.

Before we get buried in the line items (mostly in Part 2), our core view is that any expectation of positive growth in Personal Consumption Expenditures (PCE) does not make for much of a recession. It must be negative, or the recession label is a pretty lame one (example: 2001). PCE is over 68% of GDP in the recent quarter, so PCE and the consumer drive the bus on cycles.  

The softest landing that we have seen in a recession was the muted economic downturn that came after the TMT crisis and the March 2001 cyclical peak. NBER called it an 8-month recession with a trough in Nov 2001. We saw negative headline GDP growth rates only in 1Q01 at -1.3% and 3Q01 at -1.6% (source: BEA) while PCE stayed positive in both. The stock markets and HY bond markets were much worse than the overall economy. That was an underwriting quality crisis.

Given the brutal “capital markets recession,” the prolonged default cycle, and the over-the-top easing by Greenspan (see Greenspan’s Last Hurrah: His Wild Finish Before the Crisis), we imagine the NBER had to say something about the post-bubble downturn in 2001. We will look in more detail at the compare-and-contrast for that soft landing vs. today in Part 2.  The NASDAQ getting slammed in 2022 and some hot growth stocks getting crushed this year offer some parallels. New waves of risky product variations were also passed around with the Crypto pipe.

The main GDP line item movers in 2001 to the downside was the material contraction in Nonresidential Structures and Equipment. As a reminder, 2001 was the year of Enron after waves of defaults and multiyear financial collapses of speculative TMT issuers with their debt-funded capex programs (WorldCom was summer 2002).

What’s in a name?

Like the word “recession” (see Unemployment, Recessions, and the Potter Stewart Rule 10-7-22), terms such as “soft landing” get tossed around pretty freely. The generally embraced NBER official Business Cycle Dating Committee process typically assigns the start date at a significant lag to the actual recession itself (see Business Cycles: The Recession Dating Game 10-10-22 ). The lag leaves a lot of room to toss around those terms as we saw this past spring and summer. The market valuation and timing of default cycles and capital market whipsaws usually come with a very different timeline than the official recession (see Expansion Checklist: Recoveries Lined Up by Height 10-20-22).

GPDI has to get crushed for a hard landing label…

It takes a lot to get a downturn into what might be called a hard landing, and US business cycles have had some very ugly moments – notably during the stagflationary 1973-1975 recession and the 1980-1982 stagflation double dip that saw the Misery Index (unemployment + inflation) hit 22% in June 1980 (see Misery Index: The Tracks of My Fears). That was in a decade that saw negative real returns on stocks and bonds. American industry was also going through gut-wrenching structural change and deregulation across those recessions.

The bottom line is that it is hard to have a bad recession without sustained, double-digit contraction in Gross Private Domestic Investment (GPDI) or at a minimum extreme and protracted moves in its components (Nonresidential Structures, Equipment, IP, Residential investment). Low headline GDP numbers can be wagged by some other lines that can swing around (inventories, net exports), but the consumer and where industry is spending its money are the main events. “One man’s capex is another man’s revenue” is one of my older lines to invoke, and in this case it is “One man’s capex is an economist’s key GDP line item.”  GPDI is around 18% of GDP. PCE and GPDI totaled 86% of GDP with Government spending next in line at 17% before some haircut lines such as Net Exports.

We already detailed the key line items and some of the distortions that come with such line items as inventories and net exports (see 3Q22 GDP: It’s the Big Little Things 10-27-22). When growth is so low as it has been across both the Obama and Trump years (neither posted an annual GDP growth rate above a 2% handle), a swing in inventory or net exports can wipe out the growth line or, alternatively,  pad the growth into a 3% or 4% quarter.

The 3Q22 summary recap…

PCE growth has been positive each quarter since 3Q20, but that line was weak in 2Q22 at 2.0% and 1.3% in 1Q22 after a very robust 2021. GDP pushed to its highest for the year in 3Q22 at +3.2% (revised), but PCE was only at +2.3% in 3Q22. That level on PCE is vulnerable on inflation pressures and fears of recession if consumers pull back, but that gets into the whole debate around jobs and household financial health. The spending data of late is not flashing much in terms of recession anxiety trumping the desire/need to consume services.

Today’s data on household spending was constructive enough (even if slowing) after the Retail Sales number for November rattled some nerves around an economic pullback. Our core view is that the Fed will take its toll in 2023 on PCE numbers if the Fed hits what it is aiming at in demand destruction.  The theory is a weak consumer directly hits the willingness of companies to invest.

We would expect more pain in the category of Gross Private Domestic Investment (“GPDI”) in 4Q22 into 2023 with Residential investment already feeling material downward pressure at -27.1% in 3Q22 after -17.8% in 2Q22. The strength in Equipment spending under Nonresidential Fixed Investment has been an eye-opener in 2021-2022, and there are ample anecdotal stories down at the industry level where sustained high rate of capex is needed (EV, energy transition spending). That said, there are plenty of worries to add to the list for retrenchment in capex if rates keep going higher and layoffs start to flow into more setbacks in areas such as goods broadly or more narrowly consumer durables.  Goods consumption has been struggling in 2022 and consumer finance rates are moving higher in such areas as autos and appliances.

Intellectual property spending is the steadiest and most reliable GPDI line item across cycles. The questions around IT spending plans have been showing up in the headline growth stock selloffs and tech weakness. Many of the changes around automation and use of tech as productivity drivers are more secular than cyclical, but the question is still about the rate of growth in the IP line, which we expect to remain positive and healthy. Lower software spending is hard to fathom.  

We also have been in the negative zone in such categories as Nonresidential Structures for six straight quarters.  Fears around commercial real estate are creeping into the headlines, notably in Office Properties and fears of weakness in some of the formerly hot Industrial real estate areas (e.g., warehouses). As we have discussed in other notes, rising rates are usually by definition negative for real estate cycle longevity and more anxiety headlines are coloring views on real estate (see Risk Trends: The Neurotic’s Checklist 12-11-22).

Stay tuned for Part 2.

Happy Holidays!